Exploring the Frontier of Crypto Prediction Markets

Author: defioasis

Paradigm has listed the prediction market as one of the top ten areas for exploration. 1confirmation likens it to the NFT market on the eve of its explosion in 2019. Although it remains a niche track for now, as the crypto market gradually aligns with mainstream finance, key predictions of major events have become a focus for investors. In the prior prediction of whether the ‘U.S. spot BTC ETF would be approved,’ the prediction market showed tremendous potential, with Polymarket bets reaching $12.6 million. On the historic day when the BTC spot ETF was approved, Polymarket’s daily trading volume hit a record high of $5.73 million, even surpassing OpenSea’s trading volume. Polymarket is currently one of the most mainstream crypto prediction markets.

（Source: https://dune.com/rchen8/polymarket）

The year 2024 is also known as the ‘Global Election Year.’ The Global Times notes that around 2 billion people, spread across approximately 50 countries and regions, will head to the polls next year. The elections drawing significant attention include those in the United States, Russia, India, and the European Parliamentary elections, among others. Currently, Polymarket has launched a section for the U.S. elections, with bets exceeding $21.6 million across three major predictions: Republican candidates, Democratic candidates, and the presidency.

What is the prediction market?

The primary purpose of the prediction market is to forecast the outcomes of future events, such as political elections and economic indicators, through collective intelligence, often seen as a tool for information aggregation. At the same time, the prediction market is also a speculative market focused on forecasting, where users can use cryptocurrency to place real-time bets on the outcomes of political, economic, and sports events, with the option to trade before the final result is known or wait until the outcome is revealed. If the prediction is accurate, participants can win the bets of those who predicted incorrectly; if the prediction is wrong, the wagered funds become the prize for those who predicted successfully.

Taking Polymarket as an example, players can purchase shares predicting a “yes” or “no” outcome for an event at a price less than $1, with varying amounts. They can choose to take profits at a higher price or cut losses at a lower price before the result is revealed, or wait until the outcome is determined. The average price for “yes” or “no” actually represents the current collective prediction of the likelihood of that outcome by users. The sum of the average prices for both predictions equals 1, meaning the sum of probabilities is 1. However, in actual betting, due to market uncertainties and other price factors, there might be a slight deviation, causing the sum of the average prices to be slightly more than 1.

In the event “Will BTC reach $50,000 before January 31,” for instance, if Player A now bets on “yes,” buying at an average price of $0.09, they can acquire 1,111.11 shares of the “yes” outcome token (100/$0.09). If the price of BTC reaches $50,000 before January 31, Player A could gain a return of $1,111.11 on their principal; if the price does not reach, Player A loses $100; or Player A can choose to sell early for a profit or loss before the deadline.

It is evident that in the prediction market, the “yes” or “no” outcome for an event functions like binary options with a complementary relationship, or a collection of binary options superimposed on multiple events. Therefore, to maintain market integrity, the fees charged to both parties are completely symmetrical. For instance, the fee for a player buying 100 shares at $0.01 per share is the same as that for a player selling 100 shares at $0.99 per share. However, currently, Polymarket adopts a zero-fee policy for both maker and taker.

Additionally, Polymarket has introduced an order book feature for players, allowing them to wait for trades to execute at their desired prices. This feature, known as the binary limit order book, operates on a hybrid decentralized model. The system performs order matching, sorting, and execution off-chain, but the actual fund settlement occurs on-chain. The trading system uses a specialized contract built for binary markets, handling atomic swaps between binary outcome tokens and collateral assets. The asset transformation for both parties in a trade is immediate and irreversible. These binary outcome tokens are primarily CTF ERC1155 and ERC20 PToken assets. Orders are represented as signed typed structured data (EIP712).

New yield or hedging channels

On Polymarket, one can find predictions for many intriguing events. Some of these events exhibit significant volatility in their predicted outcomes. However, as the time of the event approaches and the likelihood of changes diminishes, these predictions may serve as yield or hedging tools for players with moderate risk preferences. For instance, in the aforementioned event “Will BTC reach $50,000 before January 31,” on January 11, the average price for “yes” briefly reached 0.84. But as January 31 drew near, and with the continuous pressure on BTC prices, the probability of breaking the $50,000 mark decreased. Betting on “no” at this time could yield approximately a 7.5% return. (Note: This is not investment advice.)

Law and risk

It’s undeniable that prediction markets have a speculative nature and occupy a somewhat ambiguous legal status. In 2021, the U.S. Commodity Futures Trading Commission (CFTC), responsible for regulating futures and options markets, categorized Polymarket as a binary options market. In the United States, companies offering such financial services typically need to register as Designated Contract Markets (DCM) or Swap Execution Facilities (SEF). As a result, Polymarket faced millions of dollars in fines and exited the U.S. market.

Additionally, prediction markets are similar to gambling markets and are prone to attracting regulatory scrutiny, yet there are key differences between them. Crucially, prediction markets usually lack the role of a bookmaker found in traditional casinos or some financial markets. A bookmaker, based on massive data analysis capabilities of their backing company and their profit goals, sets odds independently of the players, creating a significant information barrier between players and the bookmaker. In contrast, in prediction markets, prices are determined by the collective actions of market participants. Players make decisions based on the information available to them and logical reasoning, reflecting their ability to grasp and gather information. Betting, on the other hand, often has little to do with player skill and more with probability and luck.

Reference: https://www.tastycrypto.com/blog/polymarket/

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